“Rule of Law” is both a play on my name, and a statement of my values. The rule of law is a foundation for both our liberties and for order. The rule of law respects us as equals. It allows us to organize our lives, plan our futures, and resolve disputes in a rational way. There are those around the world and throughout history who have fought in great struggles for the rule of law. My role is more modest. I am a lawyer at the law firm of Sabey Rule LLP who works with people, assisting them with estate planning, probate and estate administration. I also assist people in resolving disputes about wills and estates. In this blog, I write about some of the legal topics that I deal with in my law practice, and about other legal issues that interest me. In doing so, I hope that I help others learn more about law, and that I encourage discussion about law and law reform. I hope that, in some small way, I help nurture the rule of law. You may contact me at my office at #201 - 401 Glenmore Rd., Kelowna, B.C., Canada; V1V 1Z6; telephone number: (250) 762-6111; email: s.rule@sabeyrule.ca.

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Sunday, January 29, 2012

McPeake v. Canada (Attorney General)

If a trust agreement does not accurately reflect the intentions of the parties creating the trust, the trustees may make an application to court to rectify the trust. The power to rectify a trust may be used to save the parties from significant taxes that they would otherwise have to pay. Taxpayers sometimes employ trusts to arrange their affairs to minimize income tax. Provided it is not a sham or done to hide property or income, the use of trusts to minimize income tax is legal in Canada. But transferring property to a trust can be tricky: if it is not set up just right, the terms of the trust may run afoul tax provisions that can result in a big and unexpected tax bill.

Barry McPeake owned one-fifth of the shares in a software development company in the 1990s. After receiving tax advice, he transferred his shares in the company to a family trust, of which he, his wife, and a legal advisor were the trustees. Members of his family were the beneficiaries of the trust. The purpose of the trust was to avoid tax if the shares were sold. Growth in the value of the shares could be allocated to the beneficiaries, who could then each use a capital gains exemption, which at that time was $500,000 on qualifying shares. The effect was that instead of there only being one $500,000 exemption available to Mr. McPeake when the shares were sold, there would be several $500,000 exemptions, significantly reducing capital gains tax.

The software development company was sold to Microsoft in 1999. Mr. McPeake’s family trust received $3,950,000 for its shares.

Canada Customs and Revenue Agency assessed Mr. McPeake for income tax on income and capital gains in respect of the shares after he transferred the shares to his family trust. The reason was that the terms of the trust document was caught by section 75(2) of the Income Tax Act, which is one of several sections containing rules that attribute income to someone who has transferred property.

In a nutshell, if after you transfer property to a trust, the terms of the trust permit the property to revert to you, or allow you to determine who the property can pass to, or if your consent is required to dispose of the property, income and capital gains are attributed back to you during your lifetime. The section says:

75. (2) Where, by a trust created in any manner whatever since 1934, property is held on condition

(a) that it or property substituted therefor may

(i) revert to the person from whom the property or property for which it was substituted was directly or indirectly received (in this subsection referred to as “the person”), or

(ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust, or

(b) that, during the existence of the person, the property shall not be disposed of except with the person’s consent or in accordance with the person’s direction,

any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of property substituted for the property, shall, during the existence of the person while the person is resident in Canada, be deemed to be income or a loss, as the case may be, or a taxable capital gain or allowable capital loss, as the case may be, of the person.

Canada Customs and Revenue Agency identified several ways in which the trust was caught by section 75 (2), some of which were fixed in a rectification proceeding in 2009, which Canada Customs and Revenue Agency did not oppose. But problems remained after the 2009 rectification. The terms of the trust required that the trustees must make decisions unanimously, which means that Mr. McPeake would have to consent to any disposal of the trust property. McPeake could also become the sole trustee, which would enable him to determine beneficiaries after the creation of the trust.

The trustees applied to the Supreme Court of British Columbia to rectify the trust document to rectify those provisions that triggered attribution under section 75(2) in McPeake v. Canada (Attorney General), 2012 BCSC 132. This time the government opposed the rectification.

In her decision, Madam Justice Dorgan neatly summarized British Columbia law on rectification as follows:

[16] Rectification is an equitable remedy that courts may apply to various legal documents that stand as instruments expressing intended legal relations. Rectifiable documents can include contracts (Performance Industries Ltd. v. Sylvan Lake Golf & Tennis Club Ltd., 2002 SCC 19, 1 S.C.R. 678 (“Performance Industries”)), land deeds (771225 Ontario Inc. v. Bramco Holdings Co. (1994), 17 O.R. (3d) 571 (Gen. Div.) (“Bramco SC”)), documents relating to corporate transactions (Juliar v. Canada (Attorney General) (1999), 46 O.R. (3d) 104 (Sup. Ct.) (“Juliar SC”)), and trust deeds (Rose v. Rose (2006), 81 O.R. (3d) 349 (Sup. Ct.)). Rectification does not change the intended legal relation: it would not, for example, change the essence of the agreement between contracting parties. Rather, rectification changes an instrument’s mistaken expression of that intention. Rectification is restorative, not “retroactive”: “[Rectification] is to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgment by one party or the other” (Performance Industries, para. 31). Since rectification restores a truth to an instrument’s expression, it acts, in time, from the point of instrument formation forward.

[17] The party seeking rectification bears the onus. For the court to exercise its equitable jurisdiction to rectify a document, a petitioner must satisfy the court that the request to rectify merely aligns the document with the true intentions underlying it, and that the aspects to be rectified are mistakes that obstruct the true intentions behind the document’s formation. Long before Binnie J. discussed rectification in Performance Industries, Vice-Chancellor W. M. James wrote in Mackenzie v. Coulson, (1869) L.R. 8 Eq. 368 at 375, “Courts of Equity do not rectify contracts; they may and do rectify instruments purporting to have been made in pursuance of the terms of contracts.”

[18] As set out in Bank of Montreal v. Vancouver Professional Soccer Ltd. (1987), 15 B.C.L.R. (2d) 34 (C.A.) at 36 - 37 (“Bank of Montreal”) by McLachlin J.A. as she then was, a petitioner for rectification of any document must establish:

1. that the written instrument does not reflect the true agreement of the parties; and
2. that the parties shared a common continuing intention up to the time of signature that the provision in question stand as agreed rather than as reflected in the instrument.
See: Joscelyne v. Nissen, [1970] 2 Q.B. 86 at 98 - 99, [1970] 2 W.L.R. 509, [1970] 1 All E.R. 1213 (C.A.); Frederick E. Rose (London) Ltd. v. William H. Pim Junior & Co., (1953), 2 Q.B. 450 at 451, [1953] 3 W.L.R. 497, [1953] 2 All E.R. 739 (C.A.).

The intention underlying the document must be more than a general intention. Exactly what constitutes sufficient specificity of intention varies by context.

In this case, Madam Justice Dorgan found that Mr. McPeake and the other parties to the trust had a sufficiently specific intention in creating the trust of maximizing capital gains exemptions on the shares of the company for the court to rectify the trust document to correspond with that intention. Accordingly, she ordered the trust document rectified so that the income and capital gains would not be attributed back to Mr. McPeake.

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Rule of Law web-log is intended for general educational purposes only, and you may not rely on its contents for legal advice. Please keep in mind that the laws of British Columbia are often different from the laws of other Provinces of Canada, States of the United States of America, and other countries. Furthermore, the law changes, and what was once an accurate statement of the law, may now be outdated and inaccurate. If you have a specific legal problem or issue, please consult a lawyer who is familiar with the laws of your province, state or country. Neither reading this blog, nor sending me an unsolicited email will create a solicitor and client relationship with me.